In Thoughts from the Frontline, I am in the middle of writing a series on debt. I realized on Sunday that the second installment wasn’t ready for prime time, so I will work on it some more and send it out (hopefully) this coming weekend. In the meantime, in keeping with the theme of debt, for today’s Outside the Box we have the following issue of The Credit Strategist from the ever-insightful Michael Lewitt. Michael starts out musing on debt and then shares a number of useful thoughts on a variety of market topics, with his usual panache.

“The day-to-day volatility of the stock market is a side-show; the real story is the massive build-up of debt and what it means for the value of the currencies in which those debts are allegedly going to be repaid in the future. The truth is that those debts are never going to be repaid in constant dollars. Those who understand that and act accordingly will profit enormously; those who don’t will fare very poorly.”

As I send this note I am flying from Orlando back to a much colder Dallas, but spring can’t be all that far off, can it? Better here than Boston, I guess. I am glad my travels have not taken me to the Land of the Frozen this winter.

Finally, I was saddened, as I know many were, to hear of the passing of Leonard Nimoy. He was, and always will be, Spock. He was part of the zeitgeist of my generation. The alien character he created with his acting made us think about what it meant to be human, in much the same way that Data did for later Trekkies. And while it is classified as sci-fi, Star Trek is a story about the human condition, and Spock was the perfect foil for the writers and creators of the stories.

I wrote a chapter in Bull’s Eye Investing called “Finding Your Inner Spock,” about the behavioral quirks that all investors have, suggesting that we all need to develop the ability to control our emotions in the investment process – by finding our inner Spock, so to speak.

Leonard Nimoy lived long and prospered, and now he boldly goes on to the next leg of his journey. I’m sure he will find it fascinating. I am, and will always be, his fan.

Your trying to understand debt analyst,

John Mauldin, Editor
Outside the Box

The Kingdom Of Denmark

By Michael Lewitt

Excerpted from the March 1, 2015 issue of The
Credit Strategist

“What is a debt, anyway?
A debt is just the perversion of a promise. It is a promise corrupted by both
math and violence. If freedom (real freedom) is the ability to make friends,
then it is also, necessarily, the ability to make real promises. What sorts of
promises might genuinely free men and women make to one another? At this point
we can’t even say. It’s more a question of how we can get to a place that will
allow us to find out. And the first step in that journey, in turn, is to accept
that in the largest scheme of things, just as no one has the right to tell us
our true value, no one has the right to tell us what we truly owe.”

– David Graeber, Debt: The First 5000 Years
(2011, p. 391)

In Hamlet,
Polonius advises his son Laertes as he sends him off to school: “Neither a
borrower nor a lender be,/For loan oft loses both itself and friend,/And
borrowing dulls the edge of husbandry.” Borrowers and lenders have conducted
themselves over the ensuing centuries in ways that would not have surprised
Shakespeare, who understood human nature all too well. Later in the play, Marcellus,
a soldier, warns Hamlet that “Something is rotten in the Kingdom of Denmark”
after they are spooked by the ghost of Hamlet’s father. This is a reference not
only to the murder of Hamlet’s father, the King of Denmark, but speaks to the
fouling of the relationships that govern the kingdom. Those relationships are
ones of blood and obligation; in one form or another, they are different forms
of debt. Debt is not merely a contract between two parties; it is a solemn pact
of trust. When it is sundered, not only is money lost but husbandry – the
management of society’s resources – is corrupted. We learn from Shakespeare’s
great drama that a world ruled by debt is extremely fragile.

February 13th marked the 25th anniversary of the
bankruptcy of Drexel Burnham Lambert. I remember driving to work at Drexel’s
Beverly Hills office that morning having no idea what was about to happen. My
years at Drexel in the late 1980s and those I spent managing the firm’s private
equity holdings in the 1990s were an intensive education in credit and human
nature. Twenty-five years after Drexel’s demise and seven years after a crisis
that pushed the global economy to the brink of collapse, the world is drowning
in debt and derivatives. As a point of reference, when Drexel filed for
bankruptcy, it had a balance sheet of $3 billion. When Lehman Brothers filed
for bankruptcy in 2008, its balance sheet was two hundred times larger at $600
billion. As Figure 1 below illustrates, debt has grown exponentially while the
global economy has crept along at a petty pace. Six years after the financial
crisis, interest rates have been driven below zero in much of the developed
world,2 a sign that policy makers have failed to create sustainable economic
growth. (The latest tally is that $1.9 trillion of European sovereign debt is
trading with negative yields.) They have managed to inflate financial assets
but left the real economy behind. For example, U.S. equity prices have gained
122% since 2009 while US nominal growth has grown by only 18% over the same
period.

Having exhausted their ability to employ interest rates as a policy
tool, policy makers are now shifting their sights to currencies to stimulate
growth. But currencies are themselves nothing more than a form of debt, a
promise by a sovereign. And those promises are being actively debauched in a
series of currency wars that are certain to end badly for those who depend on
fiat money for their daily bread.

Figure 1Unsustainable

Drexel and its aftermath taught me many lessons.
The most important is that the world of finance is the world of human nature in
all its terrible beauty. And that world is driven by incessant change. Drexel
was thought to be the most powerful firm on Wall Street, yet it collapsed
overnight. That taught all of us working there not only a lesson in humility
but a lesson in the fragility of all financial structures, especially those
built on leverage. Those who fail to acknowledge and adapt to change are always
flirting with failure. Today’s investment landscape is filled with investors,
strategists and media pundits who refuse to admit that we no longer live in a
world that can pay its debts or respond to monetary stimulus as it did in the
years before the financial crisis. Acknowledging these realities doesn’t mean
one has to stop investing or stop taking risk. But it does mean one better do
so with one’s eyes wide open.

U.S. Economy

Contrary to what the Federal Reserve, Wall
Street and much of the financial media are telling people, U.S. economic growth
is not robust. Uncritical focus on doctored economic data leads to the
conclusion that growth is self-sustaining and accelerating. In fact, growth is
sluggish and evidence that it can be sustained if interest rates ever normalize
does not exist. Normalized interest rates still lie far in the future, however,
so equity investors feel empowered to ignore these concerns and bid up stocks
‘til Kingdom come. But just as they did 15 years ago during the Internet Bubble
and 7 years ago during the Housing Bubble, when Kingdom comes it will come with
the Devil.

Figure 2 below, borrowed from Societe Generale’s
Andrew Lapthorne, shows that downgrades in US earnings forecasts in February
were the worst since the 2009 financial crisis. Mr. Lapthorne writes: “we
believe that despite the many equity indices hitting post crisis highs, the
message from within the equity market, and indeed from the strong performance
of the sovereign bond market, is that investors are positioning themselves for
an economic slowdown. For example, the relative and strong outperformance of
higher quality stocks within the equity market has been highly positively
correlated with the equally strong performance of sovereign bonds, both of
which have rallied on the back of weakening earnings momentum. To simply
disregard this economically consistent message as being simply a function of
low oil prices, low inflation and central bank actions may be misguided to say
the least.” (Andrew Lapthorne, Societe Generale Cross Asset Research, “Global
Earnings Estimates Analysis: Is the US heading back into recession?” February
24, 2015.) While Mr.Lapthorne may be placing too much emphasis on the
performance of sovereign bonds, whose yields are artificially suppressed by
massive central bank monetization programs, his point is well taken: earnings
momentum is fading and doing so beyond the energy sector. It appears
increasingly likely that S&P 500 revenues will experience their first
year-over-year decline since the financial crisis and earnings may follow. The
sharp drop in oil prices is a symptom rather than a cause of a global economic
slowdown that is showing up in a broad array of data.

Figure 2â¨No Earnings Momo

Nobody, of course, is forecasting a recession.
We are taught that recessions do not occur until the Fed tightens aggressively
and the yield curve inverts. While the yield curve has flattened significantly
over the last year, it is far from inverted.

Whether this historical rule will
apply at zero gravity remains to be seen. Trillions of dollars are counting on
it.

Washin’ the
Bullshit Down

“Whatever I was/You know
it was all because/I’ve been on the town/ Washin’ the bullshit down.” Gordon
Lightfoot

In grade school, we are taught to consider the
source of what we read in order to appreciate that all discourse is colored by
bias. Sadly, this is a lesson ignored by investors who stand to lose a great
deal of money relying on the words of central bankers, Wall Street analysts and
the financial media. Consider the bias of each of these groups as well as their
accompanying forecast records, which are appallingly bad. (I owe a head’s up to
Societe Generale’s Albert Edwards for pointing me to the studies referred to in
the following discussion in his February 12, 2015 Global Strategy Weekly.)
Recently, the San Francisco Fed published a paper entitled “Persistent
Overoptimism about Economic Growth” (February 2, 2015, FRBSF Economic Letter
2015-03) in which it found that since 2007, the Federal Open Market Committee
(FOMC) has consistently been too optimistic about U.S. growth. While that may
be stating the obvious, it bears repeating since everyo ne hangs on every word
uttered by the denizens of the Eccles Building. The authors of this paper –
themselves Fed employees (we may live in Denmark but we do not live in Russia)
– attribute these failures to several factors: missing warning signals about
financial imbalances, overestimating the efficacy of monetary policy, and extrapolating
the past into the future. To err is human; to do so repeatedly is apparently a
job requirement of central bankers.

The private sector has proven no better at
predicting recessions. The primary difference between private sector economists
and government economists is that the former are better paid to be consistently
wrong. Of course, the primary goal of private sector prognosticators is to
convince their clients to buy as many stocks and bonds as possible, so their
upward bias is not surprising. Readers looking for a comprehensive study of the
failure of private sector economists to predict recessions should look at a
presentation entitled “Fail Again? Fail Better? Forecasts by Economists during
the Great Recession” given by IMF economists Hites Ahir and Prakash Loungani at
the George Washington University Research Program in Forecasting Seminar on
January 30, 2014 (http://www.gwu.edu/~forcpgm/Ahir_Loungani.pdf).

Finally we come to the financial media, which
rarely features anything original or challenging to the bullish consensus.
Dissenting voices are either dismissed or treated as minor interruptions to an
incessant flow of happy talk. For example, Mizuho Securities USA’s Chief
Economist Steve Ricchiuto recently appeared on CNBC and told presenters Simon
Hobbs and Sara Eisen that the U.S. economy is not “accelerating” and that the
bullish consensus is nonsense. He left Mr. Hobbs and Ms. Eisen fairly
sputtering in his wake. We likely won’t see Mr. Ricchiuto back on the air any
time soon, which is a shame, because he was correct.

(Of course, CNBC was much more willing to air
the non-conforming views of one of the worst forecasters in history, former
Federal Reserve Chairman Alan Greenspan. In a February 26 interview on the
business network, Mr. Greenspan said that “Lower long term rates is [sic] not a
conundrum, it’s an indication of how weak global economic growth is” and that
“effective demand is extraordinarily weak – tantamount to the late stages of
the great depression.” Fifteen years ago, as Mr. Greenspan was steering the
economy to one bubble after another, this would have been front page news.
Today it is consigned to zerohedge.com, which is by far the most useful media
outlet for financial information on the scene today.)

With rare exceptions, the financial media
traffics in noise rather than information.

Noise is what we already know while
information is what we don’t know.

Information adds to our store of knowledge
and prompts original thinking and moves us closer to the truth. The consensus
is noise, not information. But investors need information, not noise. Valuable
analysis helps investors skate to where the puck is going rather than where
it’s been - and that means finding the flaws in the consensus and moving beyond
it. The financial media, like public and private sector prognosticators, are
noise machines. Value-added analysts are difference engines.

Figure 3 below tells us what’s really happening
in the economy. After trillions of dollars of stimulus, U.S. GDP growth is
still only 2%. People can point to the weather, lower oil prices and the strong
dollar for why the economy cannot achieve escape velocity, but the primary
reason is the suffocating weight of public and private sector debt. Even with
low (or non-existent) interest rates, an enormous amount of financial and
intellectual capital is devoted to debt service rather than more productive
uses. The result is structurally slow growth. Too much emphasis is placed on a
single data point – payrolls – which is a lagging indicator and remains far
below the levels of previous recoveries. One reason for this emphasis is that
employment is part of the Fed’s dual mandate. The employment numbers have
stabilized but they are not as robust as the headlines suggest. The broadest
measure of employment, U6, is still running above 11%. The other fi gure that
is cited to support the bullish case is GDP growth, but last year’s GDP numbers
were distorted by higher healthcare spending mandated by the Affordable Care
Act. Theoretically, helping Americans live longer and healthier lives should
lead to a more productive economy. Practically speaking, however, an economy
that can’t provide enough jobs for its healthy members may not realize the
benefits that a healthier populace would produce. Only 44% of healthy adult
Americans are members of the work force, the lowest number since the 1970s.
This is hardly the sign of an accelerating or robust economy about to take off
into the wild blue whatever.

Figure 3Difference Engine

The Deleveraging
Delusion

Last September, the Geneva-based International
Centre for Monetary and Banking Studies published a study entitled Deleveraging? What Deleveraging?
reporting that “[c]ontrary to widely held beliefs, the world has not yet begun
to delever and the global debt-to-GDP is still growing, breaking new highs.”
Going further, the report’s distinguished authors warned that, “in a poisonous
combination, world growth and inflation are also lower than previously
expected, also – though not only –as a legacy of the past crisis. Deleveraging
and slower nominal growth are in many cases interacting in a vicious loop, with
the latter making the deleveraging process harder and the former exacerbating
the economic slowdown. Moreover, the global capacity to take on debt has been
reduced through the combination of slower expansion in real output and lower
inflation.”

Now, just a few months later, The McKinsey
Global Institute has issued a report reiterating this daunting message.
McKinsey’s version, entitled Debt
and (Not Much Deleveraging), tells us that since 2007, global debt
has grown by $57 trillion, raising the ratio of global debt-to-GDP by 17
percentage points. Developing countries have accounted for half of this growth;
government debt has soared (by $25 trillion) and private sector deleveraging
has been limited. Households in the U.S., UK, Spain and Ireland have
deleveraged somewhat, but elsewhere they have not. In particular, China’s total
debt has quadrupled from $7 trillion in 2007 to $28 trillion by mid-2014,
fueled by real estate and shadow banking (but honestly, who knows what the real
numbers are?). In an anodyne statement befitting a management consulting firm,
McKinsey concludes that “(i)t is clear that deleveraging is rare and that the
solutions are in short supply.” In fact, t he solutions are not in short
supply; what is in short supply is the political and moral courage to implement
them.

Figure 4Denmark

Both the McKinsey and the Geneva reports
demonstrate beyond a shadow of a doubt the unsustainable and dangerous path on
which the global economy is set.

The question is whether global leaders will
let the train run off the tracks, or whether someone will demonstrate the
necessary leadership to take action. The message for investors is that they and
their money are living on borrowed time.

The currencies in which their
financial assets are denominated are being diminished in value every minute of
every day. Rather than sit passively and receive a crash course in nominal
value, they should actively be seeking ways to protect the real value of their
capital. In many cases, this will require them to abandon managers that aren’t
generating adequate absolute returns and shift their assets to those who have
demonstrated a genuine understanding of what is happening and an ability to
connect the dots. The day- to-day volatility of the stock market is a
side-show; the re al story is the massive build-up of debt and what it means
for the value of the currencies in which those debts are allegedly going to be
repaid in the future. The truth is that those debts are never going to be
repaid in constant dollars. Those who understand that and act accordingly will
profit enormously; those who don’t will fare very poorly.

Oil Update

Oil has rebounded by nearly 40% from January’s
lows but remains well below last year’s prices. (As of February 28, Brent crude
was trading at $62.58 per barrel compared to a low of $45.19 on January 13 and
a high of $115.00 in June 2014.) This has led to rebounds in some oil equities
and junk bonds. Investors are breathing a sigh of relief that oil producers are
reacting to the plunge in prices by sharply cutting back drilling.
Unfortunately, these efforts have yet to actually cut production;
year-over-year production is still up. Companies have idled rigs for 12
consecutive weeks, bringing the rig count to its lowest level in five years,
but they will need to do much more to stop the growth in production. The same
improving technology that gave rise to the fracking boom and the ability to
exploit the most promising acreage has rendered the rig count of limited use as
an indicator of future production.

Oil prices were hit by a perfect storm of
oversupply, slowing non-financial demand and sharply lower financial (i.e.
trading) demand. The last factor is particularly noteworthy because it was
triggered by concerns about global growth on the part of commodities traders in
early-mid 2014. It makes eminent sense that a world suffocating under an
ever-increasing burden of debt is going to struggle to grow. This is confirmed
by reams of economic data from around the world. Other economically sensitive
commodities such as iron ore, aluminum and copper are telling the same story.
Markets are living organisms, however, and the oil market is no exception. Oil
producers are cutting production as quickly as possible and oil prices are
stabilizing. The International Energy Agency is predicting that oil demand will
increase by 912 million barrels-per-day in 2015 and another 1.13 million
barrels-per-day in 2016. Rising demand will meet lower supply to stabilize
prices. The world w ill adjust. The only question is how much damage will be
inflicted on overleveraged companies in the interim.

Figure 5Whoops!

Data shows that lower gasoline prices are still
not translating into a consumer spending boom. As I have maintained all along
(to the criticism of many), cheaper gas is unlikely to send consumers racing to
the mall when the cost of healthcare and everything else is still rising. The
Bureau of Economic Analysis, an arm of the Department of Commerce, reported
that Americans spent $21.4 billion, or 18% of all spending on goods and
services, in the fourth quarter of 2014 on healthcare.

Those expecting lower gas
prices to boost consumer spending should consider Figure 5 taken from a report
by Goldman Sachs analyst Matthew J. Fassler. It shows that “the correlation
between [Wal-Mart Stores, Inc.’s] US [same-store-sales] and gas prices has been
nearly zero” since the
beginning of 2007. (Matthew J. Fassler, “Wal-Mart Stores, Inc.:
Results troughing, outlook plodding but improving nonetheless,” Goldman Sachs
Research, February 15, 2015.) Figure 6, taken from the same report, looks at
other major retailers like Sam’s Club, Target Corp. (TGT) and Costco Wholesale
Corp. (COST) and shows only marginally more evidence that lower gas prices
translate into higher retail sales, but Goldman deems the evidence
“statistically insignificant.” On its most recent earnings call, Home Depot
(HD) also confirmed that it has seen no correlation between lower gas prices
and higher spending at its stores.

Figure 6Statistically Insignificant

So where are the savings going? J.C. Penney CEO
Myron Ullman suggested that consumers are using their gasoline savings to pay
down their credit card bills or buy necessities. While many experts expect
consumers to behave as they have in the past and spend their gasoline savings
on other disposable items, perhaps they should consider that earlier periods of
sharply lower oil prices did not coincide with either higher government
mandated healthcare spending or an ecommerce revolution. Consumer behavior is occurring
in a radically different environment today and is unlikely to produce the same
kinds of consumer spending boom as it did in the past.

Credit Derivatives
in Denmark

High yield bonds performed poorly over the
second half of 2014, particularly the lowest-rated credits. Between mid-June
and mid-January, the spread on the Barclays High Yield Index widened by 185
basis points and the average bond price dropped by 7 points (performance has
since recovered). The severity of the drop was not, however, fully reflected in
the credit derivatives market; the spreads on credit default swaps (CDS) did
not widen as much as spreads on the underlying cash bonds. One possible
explanation for this anomaly is that investors are concerned that CDS contracts
will not be enforced in the manner investors expect.

The last time something
like this occurred was in 2009 when counterparty fears led investors to
question the value of CDS protection. This issue arose recently when requests
were submitted to the body that determines whether payments are required to be
made under CDS contracts in the cases of RadioShack and Caesars Entertainment
Corp. (Caesars) . This body, the ISDA Credit Determinations Committee (the
“Determinations Committee”), produced a split vote regarding Caesars even after
the gaming company defaulted on a bond payment due on December 15, 2014. This
has raised questions about the integrity of these credit protection contracts
and the stability of the markets.

Joshua Rosner of Graham Fisher & Co. has
written some excellent papers on this topic exposing flaws in the process used
to determine the occurrence of “credit events” that give rise to payments under
CDS contracts. The Determinations Committee is comprised of the 15 largest
users of credit default swaps. Ten voting members are sell-side firms and five
are buy-side firms; the list includes the usual suspects. As a result, it is
highly likely that the voting members will own a position in the instruments on
which they are being asked to vote. Further, the determinations process lacks
any of the normal procedural protections associated with what is effectively a
juridical process. The following language from the Committee’s disclosure
document highlights the problem:

The procedures of the Determinations Committees
are set forth in the DC [Determinations Committees’] Rules. A Determinations
Committee in accordance with the DC Rules may amend the DC Rules. None of the
ISDA [International Swap Dealers Association], the institutions serving on the
Determinations Committees or any external reviewers owes any duty to you in
such capacity, and you may be prevented from pursuing claims with respect to
actions taken by such persons under the DC Rules. Institutions serving on a
Determinations Committee may base their votes on information that is not
available to you, and have no duty to research, investigate, supplement or
verify the accuracy of information on which a determination is based. In
addition, a Determination Committee is not obligated to follow previous
determinations or to apply principles of interpretation such as those that
might guide a court in interpreting contractual provisions. Therefore, a
Determinations Committe e could reach a different determination on a similar
set of facts. If we or an affiliate serve on a Determinations Committee, we may
have an inherent conflict of interest in the outcome of any determinations. In
such capacity, we or our affiliate may vote and take other actions without
regard to your interests under a Credit Transaction.” (International Swaps and
Derivatives Association [ISDA] Credit Derivatives Determinations Committee
Rules, September 16, 2014 Version, http://www2.isda.org/functional-areas/legal-and-documentation/disclosures/)

To characterize this process as arbitrary would
be generous. The Committee can act without any duty to anybody, can ignore all
principles of fairness, can act in absolute secrecy, and claims to have no
liability to anybody. Investors in credit default swaps sign away all rights
when they enter into standard CDS contracts.

The members of the Committee are
authorized to act in their own interest in the name of exercising their
fiduciary duties to their own investors. Fairness and market integrity be
damned.

The Determinations Committee failed to agree
whether Caesars’ failure to make interest payments on certain bonds on December
15, 2014 constituted a default (a “credit event” in the CDS contract parlance)
that would trigger payments on $1.68 billion of notional outstanding CDS contracts
that were due to expire on December 20. While the company made it clear that it
would not make those interest payments and was planning to file for bankruptcy
pending conclusion of negotiations with bondholders, it still had a 30-day
grace period in which to change its mind and make the payment and had
sufficient cash on hand to do so.

Accordingly, some might argue that the
default did not occur until the earlier of the end of the grace period or the
date of bankruptcy filing (bondholders filed an involuntary bankruptcy petition
on January 12; the company followed with a voluntary petition on January 15).
Unable to reach a decision, the Committee is convening an exter nal arbitration
panel for the first time in six years to determine whether a “credit event”
occurred with respect to the CDS contracts that expired on December 20.

Concerns have been raised because Elliott
Management, a large Caesars bondholder that sued the company on November 25, is
one of the 15 members of the Committee. Elliott’s presence on the Committee –
indeed, the presence of any market participant on the Committee –raises serious
questions about the integrity of the determinations process. The market would
be much better served by a process that recuses interested parties from
participating in decisions involving their own investments. This would seem to
be both an obvious and an easy problem to fix; it is also an important problem
to fix in order to improve market confidence. The credit default market, while
smaller than it was before the financial crisis, is still $20 trillion in size,
large enough to pose a systemic threat.

Recently, the big banks were able to
convince Congress to keep their hundreds of trillions of derivatives contracts
inside their FDIC-insured subsidiaries. As a practical matte r, this changes
little since the size of these derivatives are so overwhelming that the
government will have no choice but to step in with some type of blanket
guarantee during the next crisis regardless of where these instruments reside.
But leaving them inside taxpayer-insured entities sends a signal that Congress
doesn’t appreciate the risk these products pose and is enabling moral hazard to
flourish. Credit default swaps constitute only 3-4% of all outstanding
derivatives yet at $20 trillion could easily wipe out the capital of the
world’s banks in the blink of an eye. The least that should be done – and done
immediately – is for an independent procedure for determining “credit events”
to be put in place. The current regime is inadequate.

Nobody can fault China's leaders for lack of bravery. The Politburo has kept its nerve as the world's most giddy experiment in credit-driven growth faces assault on three major fronts at once.

Real interest rates have rocketed. The trade-weighted rise in the yuan over the past two years has been spectacular. Fiscal policy is about to tighten drastically as the authorities clamp down on big-spending local governments.

Put together, China is pursuing the most contractionary mix of economic policies in the G20, relative to the status quo ante. Collateral damage is already visible in the sliding global prices of iron ore, copper, nickel, lead and zinc over recent months, as well as thermal coal, oil, corn and even sugar.

Zhiwei Zhang, from Deutsche Bank, says China faces a "fiscal cliff" this year as Beijing attempts to rein in spending. "This year, China will likely face the worst fiscal challenge since 1981. This is not well recognised in the market," he said.

The International Monetary Fund says China's budget deficit topped 10pc of GDP in 2014 if measured properly, including borrowing by the regions through "financing vehicles" as well as land sales - a patently unsustainable form of funding that makes up 35pc of local government revenue. This is the highest deficit of any major country in the world, and far above safe levels. A budget squeeze is already emerging as the property slump drags on. Zhiwei Zhang says land revenues fell 21pc in the fourth quarter of last year. "The decline of fiscal revenue is the top risk in China and will lead to a sharp slowdown," he said. China's Development Research Centre (DRC) - the brain trust of premier Li Keqiang - has issued a new report on the bankruptcy of California's Orange County in 1994. "It is a warning to China that the country needs to improve its tax system," said the paper. Interestingly, the DRC has also published a report recently on the decline in China's electrical, mechanical and car industries, a finding that might surprise some in the West. The Chinese tax system is highly leveraged to the property cycle, like Ireland's before the boom broke in 2007. The scale is epic. A study by the US Federal Reserve found that property investment in China has risen from 4pc to 15pc of GDP since 1998. This is even higher than in Japan in the blow-off years of the late 1980s.

The denouement is well under way. Home prices fell 3.1pc in January from a year earlier. Average sales have dropped 7pc from a year ago in the large Tier 1 cities, 22pc for Tier 2 and 15pc for the Tier 3 towns. The inventory overhang has risen to 18 months, three times US levels. New floor space has dropped 30pc on a three-month moving average. China is not the only country in Asia facing a hangover. Nomura's Rob Subbaraman says housing booms in India, Hong Kong and Taiwan all match or exceed the US bubble in 2008, with Malaysia not far behind. "Asia is setting itself up for a major credit crunch," he said.

Nomura warned that markets are relying too much on a "China policy put", betting that Beijing will always come to the rescue with more stimulus if need be. "We believe there is creeping investor complacency. We assign a one-in-three chance of a hard landing – growth averaging 5pc or less over four quarters – starting within the next two years." Premier Li appears determined to grasp the nettle, openly acknowledging that China has exhausted the low-hanging fruit of catch-up growth and reached the safe limits of credit expansion. He praised a report concluding that China will remain stuck in the "middle income trap" without a top-to-bottom overhaul of the economic system.

New regulations came into force in January that prohibit local governments from raising money off-books. If enforced fully, this will tighten fiscal policy by 5.5pc of GDP this year, roughly five times the dose in austerity in the UK each year since the Lehman crisis. That is the sort of fiscal contraction imposed on Greece. This would risk a depression. "They will have to find some way to manouvre around this, because they can't let it happen. But there are certainly risks," said Mark Williams, from Capital Economics. China cannot easily crank up monetary stimulus to cushion the fiscal shock because the "efficiency" of credit has collapsed. The economy is saturated. Extra growth generated by each extra yuan of loans has dropped from a ratio of 0.8 to 0.2 since 2008.

"Most new lending at present goes to roll over existing debt," said Diana Choyleva, from Lombard Street Research. "The appetite for ‘genuine’ credit is muted. Flooding the banks with liquidity may help relieve interbank stress, but it’s not going to feed straight into real activity." Total credit has already risen from 100pc to 250pc of GDP in eight years to $26 trillion, equal to the US and Japanese banking systems combined. Li Keqiang has clearly concluded that any further leverage compounds the danger for little useful effect. The People's Bank of China (PBOC) cut the seven-day interest rate to 5.5pc on Wednesday from 7pc, the latest in a blizzard of rate cuts. This is not monetary stimulus, or a signal that China is about to flood the world with fresh liquidity, whatever the appearances. Wang Tao, an economist at UBS, says the benchmark one-year borrowing cost for Chinese companies has jumped by 800 basis points in real terms since 2011 as inflation collapses. Business profits fell 9pc in the fourth quarter of last year. The latest cuts merely "mitigate massive tightening" already under way. "With industrial profit growth already mired in recession, risks are quickly building up in financial system," she said. China is uncomfortably close to a deflationary trap. Factory gate prices fell 4.3pc in January, a sign of excess capacity across the economy. The PBOC admitted on Wednesday for the first time that it is probing the deflation threat.

Global markets greeted the recent cuts in lending rates and the Reserve Requirement Ratio (RRR) as evidence that China is turning on the spigot once again. This is a misunderstanding. The RRR cut adds no net stimulus. It offsets monetary tightening that occurs automatically as the central bank dips into the country's €3.8 trillion foreign reserves to shore up the currency. China is no longer buying US Treasuries and global bonds. It has become a net seller, stepping in to offset accelerating outflows of capital. The capital deficit reached a record $91bn in the fourth quarter. The PBOC is now in the mirror position of boom years when it was buying foreign assets at a vertiginous pace, causing liquidity inside China to surge. All of a sudden that liquidity is draining away. There is another twist to this. The PBOC's reserve body, SAFE, was still buying $30bn a month of global bonds a year ago. It is now selling an estimated $10bn a month. This a $40bn a month shift in central bank intervention in the asset markets, a lot more than the extra $15bn a month that the Bank of Japan has been buying since October. Or put another way, Asia is "tapering" at a pace of $25bn a month. You could argue that this neutralises half the quantitative easing soon to come from the European Central Bank. A country in China's predicament normally needs a devaluation, yet China has fixed the yuan - through a "dirty float" - to a soaring US dollar. The yuan has risen 60pc against the Japanese yen and 90pc against Brazil's real since mid-2012. It has risen 27pc against the euro over the past year alone, and 110pc against the Russian rouble. Mrs Choyleva says China's true growth rate fell to 4.4pc last year, and to just 1.7pc in the fourth quarter. "Beijing needs to support growth and its only viable option is a weaker yuan," she said. The obvious danger for the world is China may be forced to defend itself as monetary disorder spreads and half the big central banks resort to currency combat. Such a fateful decision would send a deflationary impulse through a global system that has already used up its monetary ammunition and no longer has shock absorbers. China's excess capacity - made worse by $5 trillion of fixed investment in 2014 - would land with a thud in Europe and America. For now the PBOC insists that the yuan will "remain very stable". We will find out soon enough whether this means stable against the dollar, or the euro, or the yen.

BANKS are yet again in trouble—not pure investment banks such as Lehman Brothers, or mortgage specialists such as Northern Rock; but a handful of huge global “network” banks. These lumbering giants are the woolly mammoths of finance, and if they cannot improve their performance they deserve a similarly grievous fate.The pressure is intense. Last month JPMorgan Chase felt obliged to tell investors why it should not be broken up. Citigroup awaits the results of its annual exam from the Federal Reserve: if it fails, as it did last year, its managers will be for the chop. Deutsche Bank is rethinking its strategy, after years of feeble performance and drift. HSBC, the world’s local bank, has been hammered for both a tax scandal in its Swiss operation and because of its poor profits.

A shining Citi on a hill

On paper global banks make sense. They provide the plumbing that allows multinationals to move cash, manage risk and finance trade around the world. Since the modern era of globalisation began in the mid-1990s, many banks have found the idea of spanning the world deeply alluring.In practice, however, they have been a nightmare to run. Their sprawl remains vast. Citi is in 101 countries, employs 241,000 people and has over 10,000 properties. Talk of global best practice is hollow, given the misdemeanours that banks have been accused of facilitating, including money-laundering in Mexico (HSBC and Citigroup) and breaking sanctions (Standard Chartered and BNP Paribas). No boss but Jamie Dimon of JPMorgan Chase gives a convincing impression of being in full control—and even he suffered a $6 billion trading loss in 2012. Some, like Royal Bank of Scotland (RBS), having decided that they have suffered enough, have sounded a full-scale retreat and pledged to concentrate on their home markets. Others, like Citi and HSBC, are slimming down and shrinking their global presence.The wave of regulation since the financial crisis is partly to blame. Regulators rightly decided not to break up global banks after the financial crisis in 2007-08 even though Citi and RBS needed a full-scale bail-out. Break-ups would have greatly multiplied the number of too-big-to-fail banks to keep an eye on. Instead, therefore, supervisors regulated them more tightly—together JPMorgan Chase, Citi, Deutsche and HSBC carry 92% more capital than they did in 2007. Global banks will probably end up having to carry about a third more capital than their domestic-only peers because, if they fail, the fallout would be so great. National regulators want banks’ local operations to be ring-fenced, undoing efficiency gains. The cost of sticking to all the new rules is vast. HSBC spent $2.4 billion on compliance in 2014, up by about half compared with a year earlier. A discussion of capital requirements in Citi’s latest regulatory filing takes up 17 riveting pages.Partly as a result, global banks are now flunking a different test: that of shareholder value. Most of these titans struggle to make returns on equity better than (much safer) electrical utilities. Last year Citi’s was a dismal 3.4%. JPMorgan Chase estimates that its scale adds $6 billion-7 billion a year to its profits. Yet the costs of the additional capital it must carry, and of the extra rules and complexity that being global entails, offset a big chunk of that. (No other firm makes estimates this explicit, presumably because the figures would not flatter.) Up to half the capital invested in the big global banks failed to make a return on equity of 10% or more last year.Investors are asking if the costs of their global spread outweigh the benefits. If the likes of Citi and HSBC don’t buck up soon, they will be dismembered—not by regulators, but by their shareholders.Global banks insist they have a competitive advantage. No one else can do what they do. A mesh of alliances between hundreds of local banks would be rickety and hard to police; Silicon Valley has yet to invent a virtual international bank; and emerging-market contenders such as Bank of China are a decade away from having global footprints. But genuinely global activities, such as foreign-exchange trading and providing cross-border banking services to multinationals, typically account for only a quarter of big banks’ revenues.It is hard to avoid the conclusion that global banks are, by the standards of normal firms, dysfunctional conglomerates that struggle to allocate their resources well. Their bosses must now try to forge lean firms that facilitate global trade at low cost and risk. If clients find these services valuable, the banks will be able to charge enough to offset their huge overheads, and make a decent return for their shareholders on top. If clients do not, the global bank deserves to become just another of finance’s failed ideas.

.This analysis covers the long term charts of gold, gold mining shares represented by the HUI Gold Bugs Index and the world's largest gold producer, Goldcorp.Let's commence with the gold Price.

Gold

Gold has been trading as expected in recent times but there has been something in the back of my mind that has been niggling me. That is the long term chart. While I have been feeling in rhythm with gold for quite some time now, I have kept the focus on the shorter term picture. However, now it is time to confront the issue.Let's get straight to it with the yearly chart.

Gold Yearly Chart

In previous analysis, I drew a Voodoo candle which called for a spike down to below US$1000 before a big reversal higher which closed out 2015 near its highs. This was assuming the 2014 candle would be a slightly positive candle. Well, my timing has been a little off and the 2014 candle turned out slightly bearish.I can be quite finicky with how I like the picture to look and this change in "look" has been the thing that has been bothering me. However, I have turned a blind eye to it as I focused solely on the shorter term picture. Not anymore.Let's cover the lower indicators first.The Relative Strength Indicator (RSI) set a new high reading at the 2011 price high. This leads me to believe that the ultimate top is yet to be seen. I would like to see a bearish divergence set up which would require a new price high accompanied by a lower RSI reading.The RSI is trending down but it is still in positive territory so it would not surprise this indicator if price turned back up soon and went to new all time highs. Something to keep in mind.The Stochastic indicator is trending down and looking bearish. Once again, it wouldn't surprise to see this indicator turn back up but it is bearish until it's bullish.The Moving Average Convergence Divergence (MACD) indicator has made a recent bearish crossover so the likelihood is for lower prices.So, the lower indicators all appear fairly bearish and that is the bias we must have going forward until there are clear signals to think differently.There looks to be a massive "three strikes and you're out" top formation in play with the 1980 high the first strike and the 2011 high the third strike. So I definitely do not think the massive bull market is finished.I have added the trusty Parabolic Stop and Reverse (PSAR) indicator. There are two sets of dots which pertain to a tight setting PSAR and a loose setting PSAR. Price has already busted the tight setting support so the sirens have gone off on my early warning system. The probability now is for price to eventually go on and bust the dots of the loose setting support. These dots stand at US$1000.And herein lies my dilemma. I was looking for a move to sub US$1000 as I view that as an important psychological barrier that needs to be cracked. However, price cracking this barrier means cracking important PSAR support which would increase greatly the odds of lower prices.Perhaps price pulls up above the loose PSAR support and the next bull trend begins from there. Perhaps, but I don't favour that scenario. I'm going with the probability play which is the busting of tight setting PSAR support being a true early indication of the loose setting support inevitably being taken out.So how low do I expect the gold price to trade?I have drawn a Fibonacci Fan with price currently just above the 61.8% angle. There has been some support here and I expect the next 76.4% angle to also provide support. However, I think the final low will be somewhere down near the 88.6% angle.I have added Fibonacci retracement levels of the move up from 2001 low at US$255 to the all time high in 2011 at US$1920. Previously, I used the 2008 level as the starting point. That was probably due to my bullish fundamental mindset not thinking a move to below the 2008 lows was possible. Well, I should know better. Anything and everything is possible in the markets!Old highs often provide support in the future and I expect the 1980 high at US$873 to provide temporary support. However, I suspect the 1987 high at US$502 will be closer to the mark for final low.Now I have been a massive fundamental gold bull all the way down from the high and I will continue to be so all the way down to the final low. Nothing changes there for me. However, my technical view always trumps my fundamental view and I remain a technical gold bear.I am now looking for a low at the 76.4% level which stands at US$648 and possibly a touch lower. I doubt price will trade as low as the 88.6% level at US$444.What about the 50% of the all time high price level? Yes, I will still be looking closely at the price action around that US$960 level but a final low there is now not my expectation.Also, the famed Jim Rogers, who freely admits he's not a good trader, has recently come out saying he expects a move back to the 50% level. Whoa! Hold the phone!! So Jim, who openly admits he's not a good trader, is now entering the trading arena calling for a low around the 50% level. Well, byjingoes! That 50% level is already getting too much attention so I believe it is suspect and the gold price will ultimately fall much lower. While I'm with Jim on the fundamentals, I'll go my own way on the technicals.

NYSE Arca Gold Bugs Index (HUI)

The NYSE Arca Gold BUGS Index (HUI) is an index of gold mining companies with the BUGS standing for Basket of Unhedged Gold Stocks and is listed on the American Stock Exchange (AMEX). Price last traded at $180.21.We'll start with the monthly chart.

HUI Monthly Chart

There is a "three strikes and you're out" low formation in place denoted by the numbers 1, 2 and 3. This normally leads to a significant rise in price and I expect this rally is still playing out.The most recent low was accompanied by multiple bullish divergences in the lower indicators being the RSI, Stochastic and MACD. This generally leads to a more substantial rally than we have witnessed so far.The Parabolic Stop and Reverse (PSAR), indicator has a bullish bias after price busted the dots on the upside back in January.The Bollinger Bands show price is now just below the middle band and I would like to see the final rally high come in around the upper band.In a bearish development, the 100 period moving average (red) has just made a bearish crossover of the 50 period moving average (blue). Yet more bearish forces at work.I have drawn a horizontal line which denotes the 2008 low at $150.56. The recent low at $146 sets up a double bottom and considering double bottoms generally don't end trends, price should eventually come back down and bust below this level.Also, I have drawn an Andrew's Pitchfork which shows price trending down within the upper channel. Price looks to be finding support at the middle channel line and I suspect the final low, whenever that is, will be at this support line.So where do I expect the final low to be?Let's go to the big picture yearly chart in an attempt to answer that.

HUI Yearly Chart

The RSI is in weak territory while the Stochastic indicator is trending down and looking bearish with no sign of turning back up yet. There is not a lot to be pleased about here if you are a bull.

The Parabolic Stop and Reverse (PSAR) indicator has a bearish bias with the dots above bias so the coast is clear on the downside, so to speak.To my eye, it looks like a massive 5 point broadening top is in play with the 2008 high point 1, the 2008 low point 2 and the 2011 high point 3. That means price is currently making its way to a point 4 low after which price launches higher to new all time highs and eventually puts in a point 5 high.So where is the point 4 low likely to be?I have added Bollinger Bands which show the middle band has failed to provide support for price. Therefore, I believe the final low will be around the lower band and perhaps trade a bit below just as the 2011 high traded a bit above the upper band.In previous analysis, I used Fibonacci retracement levels using the 2000 low at $35.31 as the starting point. I am now having second thoughts about this believing the assumption that new record lows weren't possible being too presumptive.I suspect price can nudge marginally below the 2000 low and that is where the final low will be. Of course I will still be watching how price behaves before that, especially around the 88.6% Fibonacci level which stands at $104.08 but it is now my stance that the final low will make marginally record lows.And as always, it is just my opinion!Let's finish up by analysing the gold behemoth, Goldcorp.

Goldcorp (GG)Goldcorp Inc (GG) is a low cost gold producer with operations and development projects located throughout the Americas. It is the Big Daddy of the gold world and is listed on the New York Stock Exchange (NYSE) with a market capitalisation of around $17billion. Price last traded at $20.51.Let's begin with the yearly chart.

GG Yearly Chart

The Relative Strength Indicator (RSI) is looking weak while the Stochastic indicator is trending down bearishly. Nothing for the bulls to get excited about here.The Parabolic Stop and Reverse (PSAR) indicator has a bearish bias after price busted the dots on the downside last year.There looks to be a massive 5 point broadening top in play with the 2008 top point 1, the 2008 low point 2 and the 2011 high point 3. That means price is now headed for the point 4 low.Where is the final low likely to be?I have added Fibonacci retracement levels of the move up from 1999 low at $2.31 to the 2011 high at $56.31. I struggle to believe price will get so smashed that new lows are made but it must be given consideration. For now, I am looking for price to make a low around the 88.6% level which stands at $8.47.And once the low is in place, wherever that may be, price should then launch to all time highs as it searches for a point 5 high.Let's move on to the monthly chart.

GG Monthly Chart

There is a "three strikes and you're out" low formation in place which is denoted by the number 1, 2 and 3.The lower indicators, the RSI, Stochastic and Moving Average Convergence Divergence (MACD), are all showing multiple bullish divergences at this recent low and I expect a more substantial rally than we have so far seen in response to that.The PSAR indicator has a bearish bias with the dots over price but I suspect a pattern of dots being busted every which way is occurring which is an indication of corrective price behaviour. The dots are currently at $26.18 and I expect price to take them out.I have drawn two trend lines which form a downtrend channel and I am looking for the final rally high to be at resistance given from the top of the channel.I have added moving averages with time periods of 50 (blue) and 100 (red) and we can see they are just now making a bearish crossover. And this is the monthly chart so it is a solid indication of a downtrend in progress.After the coming rally high I expect price to get crunched and fall to new lows. There will probably be a reaction off the 2008 low level which stands at $13.84 and is denoted by the horizontal line. After a brief reaction higher, price should then break down below the lower trend line as the downtrend gains momentum.

Disclosure: I have no financial interest in GG.

Summary

Finally, to touch on the psychology of the gold market, there still appear way too many market participants and commentators that are bullish gold and expect this year to see in the final low. This was giving me a major case of the heebie-jeebies recently as I had the same outlook. It is pretty hard to find any analysis that is more than a little bearish and I now feel much more comfortable being against the overwhelming majority opinion.Summing up, I expect deflationary forces to really pick up later this year and gold will not be spared despite the opinion of the masses.And once this deflationary cycle has caused maximum damage to the bank accounts and psyche of the gold bulls, the long awaited boom should see the gold price explode higher as inflationary euphoria finally takes hold.

WASHINGTON, DC – One of the factors driving the massive rise in global inequality and the concentration of wealth at the very top of the income distribution is the interplay between innovation and global markets. In the hands of a capable entrepreneur, a technological breakthrough can be worth billions of dollars, owing to regulatory protections and the winner-take-all nature of global markets. What is often overlooked, however, is the role that public money plays in creating this modern concentration of private wealth.

As the development economist Dani Rodrik recently pointed out, much of the basic investment in new technologies in the United States has been financed with public funds. The funding can be direct, through institutions like the Defense Department or the National Institutes of Health (NIH), or indirect, via tax breaks, procurement practices, and subsidies to academic labs or research centers.

When a research avenue hits a dead end – as many inevitably do – the public sector bears the cost. For those that yield fruit, however, the situation is often very different. Once a new technology is established, private entrepreneurs, with the help of venture capital, adapt it to global market demand, build temporary or long-term monopoly positions, and thereby capture large profits. The government, which bore the burden of a large part of its development, sees little or no return.

One example, flagged by the economist Jeffrey Sachs, is Sovaldi, a drug used to cure hepatitis C. As Sachs explains, the company that sells it, Gilead Sciences, holds a patent for the treatment that will not expire until 2028. As a result, Gilead can charge monopoly prices: $84,000 for a 12-week course of treatment, far more than the few hundred dollars it costs to produce the drug. Last year, sales of Sovaldi and Harvoni – another drug the company sells for $94,000 – amounted to $12.4 billion.

Sachs estimates that the private sector spent less than $500 million on research and development to develop Sovaldi – an amount that Gilead was able to recoup in a few weeks of sales. The NIH and the US Department of Veterans Affairs, however, had heavily funded the start-up that developed the drug and was later acquired by Gilead.

There can be no doubting that the imagination, marketing savvy, and management skills of private entrepreneurs are critical to the successful application of a new technology. And the lower prices, better products, and consumer surplus provided by the commercialization of many innovations clearly provide large societal gains. But one should not overlook the role of government in these successes.

Joint OECD-Eurostat data show that direct government expenditures accounted for 31% of R&D spending in the US in 2012. Adding indirect expenditures, like tax breaks, would bring this figure to at least 35%. Thanks to such public outlays, a few private players are often making huge returns, which are a major cause of excessive income concentration.

There are several ways to change such a system. Rodrik proposes the creation of public venture capital firms – sovereign wealth funds – that take equity positions in exchange for the intellectual advances created through public financing. Another solution would be to reform the tax code to reduce returns when an individual or firm is cashing in on publicly funded research.

Both solutions face difficulties. Sovereign wealth funds would have to be shielded from partisan politics, perhaps by giving them only non-voting shares. Raising taxes on the beneficiaries of publicly funded research would be a challenge, given that the link between an original breakthrough and the wealth it created might be hard to quantify. There is also the complication of global capital mobility and tax avoidance, which the G-20 is only beginning to address.

Other approaches are also possible: tightening up patent laws or imposing price controls for monopolistic industries, such as pharmaceuticals, as many market economies have done. What would not be a solution, however, would be to channel fewer public resources into research and innovation – key drivers of economic growth.

It does not take huge rates of returns to mobilize a lot of talent; something like a 50% profit margin for a few years would be an acceptable reward for particularly good entrepreneurship. Multiples of that amount, however, simply end up as gifts by the public to a few individuals. A combination of measures and international agreements must be found that would allow taxpayers to obtain decent returns on their investments, without removing the incentives for savvy entrepreneurs to commercialize innovative products.

The seriousness of this problem should not be understated. The amounts involved contribute to the creation of a new aristocracy that can pass on its wealth through inheritance. If huge sums can be spent to protect privilege by financing election campaigns (as is now the case in the US), the implications of this problem, for both democracy and long-term economic efficiency, could become systemic. The possible solutions are far from simple, but they are well worth seeking.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.